Who Is Saudi Arabia Really Targeting In Its Price War?

Saudi Arabia is not trying to crush U.S. shale plays. Its oil-price war is with the investment banks and the stupid money they directed to fund the plays. It is also with the zero-interest rate economic conditions that made this possible.

Saudi Arabia intends to keep oil prices low for as long as possible. Its oil production increased to 10.3 million barrels per day in March 2015. That is 700,000 barrels per day more than in December 2014 and the highest level since the Joint Organizations Data Initiative began compiling production data in 2002 (Figure 1 below). And Saudi Arabia’s rig count has never been higher.

Market share is an important part of the motive but Saudi Minister of Petroleum and Mineral Resources Ali al-Naimi recently emphasized that “The challenge is to restore the supply-demand balance and reach price stability.” Saudi Arabia’s need for market share and long-term demand is best met with a growing global economy and lower oil prices.That means ending the over-production from tight oil and other expensive plays (oil sands and ultra-deep water) and reviving global demand by keeping oil prices low for some extended period of time. Demand has been weak since the run-up in debt and oil prices that culminated in the Financial Collapse of 2008 (Figure 2 below). Related: Is This Where Investors Should Be Looking When Oil Recovers?

Figure 2. World liquids demand (consumption) as a percent of supply (production) and WTI crude oil price adjusted using the consumer price index (CPI) to real February 2015 U.S. dollars, 2003-2015. Source: EIA, U.S. Bureau of Labor Statistics, and Labyrinth Consulting Services, Inc.

(click to enlarge image)

Since 2008, the U.S. Federal Reserve Board and the central banks of other countries have further increased debt, devalued their currencies and kept interest rates at the lowest sustained levels ever (Figure 3 below). These measures have not resulted in economic recovery and have helped produce the highest sustained oil prices in history. They also led to investments that are not particularly productive but promise higher yields that can be found otherwise in a zero-interest rate world.

The quest for yield led investment banks to direct capital to U.S. E&P companies to fund tight oil plays. Capital flowed in unprecedented volumes with no performance expectation other than payment of the coupon attached to that investment.This is stupid money. These capital providers are indifferent to the fundamentals of the companies they invest in or in the profitability of the plays. All that matters is yield.The financial performance of most companies involved in tight oil plays has been characterized by chronic negative cash flow and ever-increasing debt. The following table summarizes year-end 2014 financial data for representative tight oil-weighted E&P companies.

Some rationalize the negative free cash flow as an expansion of capital base that will result in future profits. The following table shows that over the past 4 years, tight oil negative cash flow increased and has reached a cumulative of more than -$21 billion for the representative companies. Almost half of that negative cash flow took place in 2014.

The average U.S. oil price from January 2011 through year-end 2014 was $95 per barrel. First quarter 2015 performance at $48.50 WTI will be a disaster that makes the previous 4 years look good.

How long do the losses continue before the cheerleaders of shale plays admit that the enterprise is not profitable? Only the more diversified integrated companies like ConocoPhillips, Marathon, and OXY show meaningful long-term positive cash flow. If companies could not show positive cash flow at $95 per barrel, what price is necessary and what will that do to the world economy? Related: Wall Street Bets On Oil Price Rally

Some of my readers dispute the poor economics of these plays based on incorrect notions of break-even profitability–some believe that tight oil plays are profitable at $35 per barrel oil prices (see comments from my last post).

Following are two slides taken from Schlumberger CEO Paal Kibsgaard’s recent presentation at the Scotia Howard Weil 2015 Energy Conference held in New Orleans. These slides present a well-informed and objective view of how tight oil plays compare to other plays.

In my Figure 4, Mr. Kibsgaard shows that the average break-even price for tight oil plays is about $75 per barrel. By comparison, Middle East OPEC break-even prices are less than $10 per barrel. Other conventional oil plays break even at less than $20 per barr

In my Figure 5, Mr. Kibsgaard shows Schlumberger’s assessment of drilling intensity or efficiency. For nearly equal oil-production volumes of about 11 million barrels per day, U.S. oil producers drilled more than 35,000 wells and 297 million feet of hole compared to 399 wells and 3 million feet of hole for Saudi Arabia. Related: Saudi Price War Strategy May Blow Up In Their Face

Figure 5. Slide from Schlumberger CEO Paal Kibsgaard’s presentation at the Scotia Howard Weil 2015 Energy Conference.U.S. companies drilled almost 100 times more wells to reach the same daily production as Saudi Aramco. Strident claims of increased efficiency by tight oil producers sound absurd in this context.

Prolonged low oil prices will prove that tight oil plays need at least $75 per barrel to break even. When oil prices recover to that level, only the best parts of the tight oil core areas will be competitive in the global market. As production declines from expensive tight oil, oil sand and ultra-deep-water plays, inexpensive Saudi oil will gain market share.

Saudi Arabia is not trying to crush tight oil plays, just the stupid money that funded the over-production of tight oil. Too much supply combined with weak demand created the present oil-price collapse. Saudi Arabia hopes to prolong low prices to benefit their long-term needs for market share and higher demand.

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Thanks for the post Mr. Berman. The only question is, will the Saudis have enough excess capacities to satisfy the growing demand and for how long under this low price environment. I thought the only reason the tight oil come to be was because conventional oil was insufficient to satisfy world demand. If that is the case, then the Saudis cannot hold off price increase for long as they don't have enough capacity.

John Scior on April 21 2015 said:

You say that central bankers efforts to kep interest rates low has not stimulated the economy. On the contrary, if politicians had worked together to pass spending bills tosay build better roads or other typical stimulus measures ,then the fed might not have had to step in. Their low interest rate policy did indeed lift the economy out ofthe worst economic downturn since the great depression. The tight oil plays come about because everyone assumes that supply remains constrained and Libyan as well as Iraqi oil stays out of production forever.It did indeed come back online and without cooperation from the other oil producing countries, the Saudis were not going to forgo production only to have it fulfilled elsewhere. Since they have the largest proven and cheapest to extract oil reserves, they are a market maker as far as prices are concerned. Their objective is to hurt all the other producers until all players come to the negotiating table and set reasonable targets to allow for Iraq and Libya resumption of oil production without everyone losing out and there being fierce competition to see who can provide oil the cheapest. Your theory is paranoid mania in that it fosters some "conspiracy" theory that the Saudi's are out for vengence or to target a specific group. All their actions suggest is that they are looking out for their own interests. Perhaps they realize that the development of alternative fuels such as biofuels or electric cars might be displacing their dominance in an economic sector and if , and I say if, they still have 200 Billion barrels still in the ground, it might be prudent in the short term to suffer some economic losses to protect the long term viability of oil as a resource before those proven resource become as valuable as confederate dollars.

Andrew on April 21 2015 said:

John Scior is spot on here. To think that KSA is working to harm a specific player in the oil market is near-sided. Their goal is to protect their own assets and anything beyond that is simply consequential.

J M on April 21 2015 said:

The Saudis are waging economic warfare on the U.S. oil & gas industry. The first slide tells the story, in spite of the article's twisted logic and attack of the U.S. investment banking community. The Saudis have not advanced their recovery technology nearly as effectively as U.S. industry, they know it, they are substantially over-producing to sustain a low price to drive successful U.S. producers out of business. They are succeeding. With the tacit agreement of the U.S. executive branch.

This from our so-called allies, for whom we send our sons to war to protect Saudi interests, waste American lives, spend military billions annually to protect shipping of their heavy oil, the reward for which is the royal family's direct contributions to the Taliban and the 9/11 attack and murder of U.S. citizens. Congress needs to let all American citizens finally read the 28 redacted pages of the 9/11 Report and know the truth about those we protect and bow down to.

Not a perfect solution, but a step in the right direction,

Gary on May 19 2015 said:

I accept his argument but not the conclusion. If we can't make a profit and lose a minimum of 5 million barrels per day from the USA, can OPEC make up the difference? Poster John brought up the same argument. The second concern is at what date will all of OPEC run out of reserves? It is not a question of if, but when. The USA shale players need about another $15 to be profitable. OPEC countries need about $38 to remain a Nation. Who really is in more trouble?

Matt on July 15 2015 said:

Energy independence is a powerful tool, not for fools. One to lower the oil price so removal of sanction against Iran are less effective. Two Obama would not be throwing the Saudi's under a push if W had not left energy independence behind. It is not to screw allies over but a contingency in case something occurs.